Managerial Economics eighth edition Thomas Maurice Chapter 5

Managerial Economics eighth edition Thomas Maurice Chapter 5 Theory of Consumer Behavior The Mc. Graw-Hill Series

2 Managerial Economics Utility • Benefits consumers obtain from goods & services they consume is utility • A utility function shows an individual’s perception of the utility level attained from consuming each conceivable bundle of goods 2 The Mc. Graw-Hill Series

3 Managerial Economics Theory of Consumer Behavior • Assume consumers have complete information about availability, prices, & utility levels of all goods & services • All bundles of goods can be ranked based on their ability to provide utility – for any pair of bundles A & B: • Prefer bundle A to bundle B • Prefer bundle B to bundle A • Indifferent between the two bundles 3 The Mc. Graw-Hill Series

4 Managerial Economics Indifference Curves • Locus of points representing different bundles of goods, each of which yields the same level of total utility • Negatively sloped & convex • Marginal rate of substitution (MRS) • Absolute value of the slope of the indifference curve • Diminishes along the indifference curve as X increases & Y decreases 4 The Mc. Graw-Hill Series

5 Managerial Economics Typical Indifference Curve (Figure 5. 1) 5 The Mc. Graw-Hill Series

6 Managerial Economics Indifference Map Quantity of Y (Figure 5. 3) IV III II I Quantity of X 6 The Mc. Graw-Hill Series

7 Managerial Economics Marginal Utility • Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption, holding constant the amounts of all other goods consumed 7 The Mc. Graw-Hill Series

8 Managerial Economics Marginal Rate of Substitution • MRS shows the rate at which one good can be substituted for another while keeping utility constant • Negative of the slope of the indifference curve • Ratio of the marginal utilities of the goods 8 The Mc. Graw-Hill Series

9 Managerial Economics Consumer’s Budget Line • Shows all possible commodity bundles that can be purchased at given prices with a fixed money income 9 The Mc. Graw-Hill Series

10 Managerial Economics Typical Budget Line (Figure 5. 5) Quantity of Y • A B • Quantity of X 10 The Mc. Graw-Hill Series

Managerial Economics 11 Shifting Budget Lines (Figure 5. 6) 100 80 R A Quantity of Y 120 F N C B D 160 200 240 125 200 250 Quantity of X Panel A – Changes in money income The Mc. Graw-Hill Series A B Z 11 100 Quantity of X Panel B – Changes in price of X

12 Managerial Economics Utility Maximization • Utility maximization subject to a limited money income occurs at the combination of goods for which the indifference curve is just tangent to the budget line 12 The Mc. Graw-Hill Series

13 Managerial Economics Utility Maximization • Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all commodities purchased 13 The Mc. Graw-Hill Series

14 Managerial Economics Constrained Utility Maximization (Figure 5. 7) 50 Quantity of pizzas 45 • A 40 • B • D E IV • R 30 III 20 C • 15 10 0 10 20 30 40 50 60 Quantity of burgers 14 The Mc. Graw-Hill Series 70 II T I 80 90 100

15 Managerial Economics Individual Consumer Demand • An individual’s demand curve for a specific commodity relates utilitymaximizing quantities purchased to market prices • Money income & prices held constant • Slope of demand curve illustrates law of demand—quantity demanded varies inversely with price 15 The Mc. Graw-Hill Series

16 Managerial Economics Market Demand • List of prices & quantities consumers are willing & able to purchase at each price, all else constant • Derived by horizontally summing demand curves for all individuals in market 16 The Mc. Graw-Hill Series

17 Managerial Economics Derivation of Market Demand (Table 5. 1) Quantity demanded 17 Price Consumer 1 Consumer 2 Consumer 3 Market demand $6 3 0 0 3 5 5 1 0 6 4 8 3 1 12 3 10 5 4 19 2 12 7 6 25 1 13 10 8 31 The Mc. Graw-Hill Series

18 Managerial Economics Derivation of Market Demand Figure (5. 9) 18 The Mc. Graw-Hill Series

19 Managerial Economics Substitution & Income Effects • When price changes, total change in quantity demanded is composed of two parts • Substitution effect • Income effect 19 The Mc. Graw-Hill Series

20 Managerial Economics Substitution & Income Effects • Substitution effect • Change in consumption of a good after a change in its price, when the consumer is forced by a change in money income to consume at some point on the original indifference curve • Income effect • Change in consumption of a good resulting strictly from a change in purchasing power 20 The Mc. Graw-Hill Series

21 Managerial Economics Income & Substitution Effects: A Decrease in Px (Figure 5. 11) Total effect of = Substitution+ Income price effect decrease 9 = 5 + 4 21 The Mc. Graw-Hill Series Total effect of = Substitution+ Income price effect decrease 3 = 5 + (-2)

22 Managerial Economics Substitution & Income Effects • Consider the substitution effect alone: • Amount of good consumed must vary inversely with price • Income effect reinforces the substitution effect for a normal good & offsets it for an inferior good 22 The Mc. Graw-Hill Series